Metaeconomics - Markets

In my other posts on the subject of Metaeconomics I have been critical of economists.  In this post I cover a subject that I think Economics and Economists generally do a good job with.  But it is a subject that is misunderstood and abused in general public discourse.  So there is more the flavor of a primer than a critique to this post.  I will, however, apply the lessons learned from a serious discussion of markets to some real world situations.  So, . . .

What is a market?  Here am not talking about a supermarket or a public market like a flower market or other place where people congregate to buy and sell but rather what economists and politicians are talking about when they use the word.  Rather than starting with a definition I am going to start with an example, the wholesale wheat market.

There are literally thousands of wheat farmers in the country.  Each has his own cost structure.  Some can produce wheat relatively cheaply but for others the cost of production is much higher.  So if farmers are getting a certain price for wheat a certain number of them are making a profit and the rest are not.  All this information is usually aggregated together into a "cost curve".  If the price of wheat is low then only a few farmers can produce it profitably.  As the price rises more and more farmers can make a profit.  If the price is particularly high then pretty much every farmer and his brother in law can profitably produce wheat.

If we graph this we typically get a "knee shaped" curve.  Price is usually laid out on the horizontal axis with low prices on the left.  The vertical axis tracks how much wheat can be profitably produced.  Typically at a low price only a small amount of wheat can be profitably produced.  As we slowly increase the price the amount of profitable wheat increases slowly.  The line on the graph rises slowly.  At some point it starts getting pretty easy to produce wheat profitably.  The line starts curving sharply up.  And so on.  The line ends up looking like a leg bent at the knee where it is pretty straight and horizontal and then it bends up more toward the vertical.  Hence the name.

Now lets go through the same exercise only with people who buy wheat.  If the price is high then few people are interested.  As you slowly lower the price then more and more people are interested but interest grows slowly.  But at a low price then all of a sudden lots of people get interested in buying wheat.  So we see the same knee shaped curve only it has been flipped to become a mirror image.  It is pretty flat and rising only slowly as we move from right to left (the opposite direction as we did with the supply curve).  Then at some point the curve bends up sharply as the price gets to be low.  So again we have a curve with a knee in it.

Now let's put both curves on the same graph.  We have the supply curve with the high part of the knee on the right (high price) end of the graph and the demand curve with the high part of the knee on the left (low price) end of the curve.  This is the kind of graph used in all introductory economics classes to describe "supply and demand".  And the curves should cross.  There should be a point where the "supply" graph crosses the "demand" graph.  In a market that is supposed to be where the price settles.  Why?  Because at that point supply and demand are in balance. But that's only the starting point of our discussion.

Let's say for some reason the price is below (to the left of) the "equilibrium point", the point where supply and demand are in balance.  At this point the "demand" line is above the "supply" line.  But that means that a bunch of people want wheat and are willing to pay more than the current price.  What should happen is that they bid the price up.  This means we move to the right toward a higher price.  This higher price attracts more supply and the market moves closer to equilibrium.  Similarly, what if somehow the price is above (to the right of) the equilibrium price?  Then purchasers decide to exit the market because they can't buy wheat at a price that makes sense to them.  There are lots of sellers (supply line is high) but not enough buyers (demand line is low).  Suppliers find that they can't find buyers for the wheat they want to sell and the price moves lower.  The price moves to the left toward the equilibrium price.  That's why it is called the equilibrium price.  Any deviation puts pressures on the market to move toward the equilibrium price.  Only at the equilibrium price are market forces in balance.

Economists assume that's how markets work.  If the price is above or below the equilibrium price then "the invisible hand of the marketplace" will be seen moving the price toward the equilibrium price.  So one attribute of a "market" is that "market forces" always move the price toward the equilibrium price.  Now economists make two assumptions they don't talk about.  The first is that there is an equilibrium price.  And the second is that market forces exist and that they always move the market price toward the equilibrium price.  Now if the "supply curve" is this nice knee shaped curve and the demand curve is this nice knee shaped curve both of these assumptions are true.  And they don't have to be exactly knee shaped.  Mathematically, the supply curve needs to be "continuous" and "monotonically increasing".  Similarly, the demand curve needs to be "continuous" and "monotonically decreasing".  Continuous means no kinks or gaps.  Monotonically increasing/decreasing means the curve always goes up/down at least a little as you move from left to right.  If these assumptions are not true then there may be no equilibrium price (or more than one) or there may be no "market force" to move the price.  Or, worst of all, the market force may move the price in the wrong direction.

There is another simplification going on.  In introductory economics classes all the analysis starts out using static curves.  They don't change with time.  Once the basics have been covered then the idea that the curves may change with time is introduced.  But this is usually done in a very simplistic manner.  Frequently a situation where the shape of the curve remains the same but the whole curve is slid slightly up or down the price axis is the only one discussed in any detail.  This vastly underestimates the complexity of the real world.

Most obviously either or both curve may not be the pretty knee shape from the textbook.  It may have twists and turns.  You can roughly calculate the "market force" that pushes the price toward its equilibrium point by looking at the distance between the curves.  A big distance results in a big force and the price moves quickly.  A small distance results in a small force and the price moves slowly.  This kind of thinking allows economists to calculate the "price trajectory" of a market.  But if the curves are more complex the market force may become less predictable and the price trajectory essentially a mystery.

Another assumption is that the curves move slowly and smoothly.  But "price discontinuities" are common in the real world.  A curve may be abruptly replaced by a curve with a considerably different shape located in a different place on the price scale.  This too throws any kind of traditional economic analysis out the window until things settle down.  Wars, bankruptcies, and regulatory changes, are a few examples of events that can have a radical impact on one or both curves.

Finally, wheat is traded in a "pit" at the Chicago Board of Trade.  The pit represents the marketplace.  It performs two functions.  First, it brings together a large number of buyers and sellers.  And second, it records and publicly broadcasts the results of transactions.  The price and quantity of each wheat sale is recorded and distributed publicly. 

That leads me to my definition.  A "market" is a situation where you have a commodity, in this case wheat.  There are a large number of independent buyers and sellers.  There is a marketplace where sales are recorded and the information is distributed.  So price and quantity information for each sale is publicly available.  And finally, prices conform to the attributes of a market.  There is an equilibrium point, although it can change with time.  And market forces move the price toward the equilibrium point.

The wholesale market for wheat is a classic "market".  Let's look at the opposite, a natural monopoly.  Consider sewerage.  Your house generates sewerage.  Buildings and businesses generate sewerage.  There's lots of supply.  But there's no demand.  No one wants the stuff.  Theoretically this could be fixed by considering negative prices.  "I will buy a gallon of your sewerage for -$10".  In other words, you will pay me $10 to take away a gallon of your sewerage.  In terms of the graph and curves this works just fine.  So mathematically there is no problem.  But there is a practical consideration.  Sewerage is usually transported through underground pipes.  It is fantastically expensive to install and maintain this system of pipes.  No one is going to take a flyer and build a sewerage system "on spec" in the hopes that they can eventually turn a profit.

From a practical point of view building and maintaining sewerage systems ended up being handed over to government.  City and county governments build and maintain sewerage systems.  Things work like a market in the sense that negative prices are paid (fees are collected) for the product.  But you have many independent sellers (for a negative price) and only one buyer in an area.  This results in no market pressure.  Political pressure is substituted.  Elected politicians are pressured to provide a good quality of service for a "reasonable" price.  Is the price the proper "equilibrium price" we would expect of a market?  There is no way to know.

We are all familiar with natural monopolies.  We know them as "utilities".  The common utilities, besides sewerage, are water, electricity, electric power, telephone, cable TV, and natural gas.  Recently the FCC decided to add another, Internet access.  Ignoring Internet access for a moment, the latest addition to the list is Cable TV.  It is possible to imagine multiple cable TV companies competing for your business but that never really worked out.  One company usually was able to sign up way more customers than anyone else.  At that point, in a financial calculation that mirrors the "sewer pipe" scenario I discussed above, other companies decided it was too risky to lay out the money to run the necessary wiring to each person's house.  There may be a market served by two cable companies somewhere in the U.S.  But I don't know where it is.  And theoretically satellite TV delivery represents competition.  But so far most people opt for wired cable over satellite cable.

And let me turn for a minute to a traditional utility:  phone service.  Not that long ago the only practical way to provide phone service was to run wires all over the place and install an expensive "central office" facility in each neighborhood.  This led to the standard "utility" situation where it was not practical for a second company to come along and spend the large amount of money necessary in hopes of picking up enough business to make a profit.  But this model in on longer the whole story.  Duplicating the traditional wiring plant of an old line phone company is still fantastically expensive.  However, it is no longer necessary.

It is now possible to use Voice over IP (VoIP) technology to replace all that wiring.  So you have companies like Vonage and Skype.  An inexpensive box can bridge the traditional phone wiring in your house so that your phones are connected over the Internet.  Beyond that is the mobile phone business represented by companies like T-Mobile and Verizon.  The typical homeowner now has a half a dozen alternatives to the traditional "land line" approach to providing telephone service.  As a result I believe that the regulatory burden of land line phone companies should be drastically reduced.  All pricing regulation should be eliminated.  I would even be open to reducing the "must serve" requirement.  Now land line phone companies must provide service to everyone in their service area regardless of cost or difficulty.  A small amount of regulation should remain, 911 service, a few other things like that, but the rest should be dropped.

This "you have to spend fantastic amounts of money up front" attribute is what defines natural monopolies.  Where there is no practical way to get multiple providers we are forced to fall back on a regulatory approach as a substitute for the "market forces moving us toward the equilibrium price" action of a functioning market.  Frankly, Internet providers have been behaving like natural monopoly players for some time.

In the early days Internet service was provided via dialup modems.  It was relatively easy and relatively inexpensive to set up a service.  To switch providers all a customer had to do was change the phone number his modem dialed and a few other things.  So we had a lively market frequently consisting of a half a dozen or more viable options.  Then (initially not very) "high speed Internet" came along.  There were two technology options.  Cable companies figured out how to piggyback Internet service on the same wiring used to deliver the cable signal.  This allowed them to use the same wiring to distribute both Internet and cable service.  They had to add equipment at their office and at the customer end.  But once that was done the system worked well and instantly became a big moneymaker.

And when this technology was initially being rolled out the cable companies were supposed to lose to the telephone companies.  There was a technology called DSL that was supposed to be much better than anything the cable companies could come up with.  But DSL never lived up to its promise.  DSL was supposed to allow the phone companies to do the same thing as the cable companies, namely piggyback an Internet signal over the already existing phone line.  So, like the cable companies, they would not have to string any additional wires, just put some more equipment in their offices and another box in the customer's home.  The problem is that it never really worked.  Only some phone lines were suitable.  It turned out that most phone lines weren't.  So the phone companies could not DSL most of their customers.  But the cable companies could Internet all of their customers.  And then the advantage the phone companies were supposed to have went away.  The cable companies kept upping their speeds.  Soon DSL was slower than cable.  As a result of all this phone companies were never able to roll out enough DSL installations to make the business profitable. 

So today the "Internet access from home" business belongs 90+% to the cable companies.  Given this situation it makes complete sense that the FCC has decided that Internet access needs to be regulated like the natural monopoly it is, in other words like a utility.  The cable companies have been squawking.  But the FCC says it is not going to regulate prices.  As a result, the price of the stock of the major cable companies went up the day the FCC made its announcement.  I expect the squawking to dry up pretty quickly.

Having looked at the extremes I now want to look at a commodity that lies somewhere between, money.  And let me start with the most basic question of all: what's money?  My definition of money is "tangible value".  We all have an intuitive idea what the word "value" means.  What money does is turn that intuition into a tangible thing.  You can hold money in your hand.  More importantly, you can trade money for valuable things (food, jewelry, etc.) and you can trade valuable things (jewelry, labor) for money.  A unit of money, say a dollar, is the tangible incarnation of a unit of value (the worth of a dollar).

Theoretically, a unit of money is supposed to have a constant value.  That allows us to trade one thing of value for an appropriate amount of money and then turn an appropriate amount of money into some other thing of value.  And theoretically the value of money should remain constant over time.  That lets you borrow a certain amount of value in the form of a specific amount of money and then return the same amount of value in the form of the same amount of money later.  This is a temporal transaction.  You can also turn something valuable (i.e. labor) into money (i.e. a paycheck) and then immediately turn that money back into a different something valuable (i.e. groceries).  Think of this as a lateral transaction.  And money allows you to mix temporal transactions with lateral transactions and it allows you to mix transactions involving different amounts of value/money.  That's very convenient.

Actually economists have determined that for reasons of economic health the value of money should decrease slowly over time.  Why?  It is often difficult to reduce the price of many goods.  But for economic reasons it is important that those prices be reduced.  Inflation, the hopefully slow decrease in the value of a unit of money does this automatically.  Since the value of money has turned out to never be exactly constant the economy has developed many methods of dealing with low rates of inflation.  And it would appear that even a small amount of deflation (the opposite of inflation - the increase in the value of a unit of money) is destructive to economies.  The details are complex so I am going to skip them.

Then there is the idea of tying the value of a unit of money to a specific quantity of a commodity.  Over time many things have been tired:  Salt, sea shells, beads, and silver are some of the commodities that have been tried out at some place or some time or another.  And then there is the modern favorite:  gold.  I am going to use gold as my example of why this does not work as well as people think it does.

When I was a kid the price of gold was pegged to the dollar.  An ounce of pure gold would get you $35 and vice versa.  Then in 1972 the price of gold was set free.  It immediately went up a lot.  This was what everyone expected.  It was why the U.S. went off the "gold standard".  After not too long a time it soared to $200/oz.  Then it crashed to under $100.  A few years later it soared to over $800/oz then it crashed again.  It stayed under $800 for many years.  Then a few years ago it started rising.  It went up and up and up.  It eventually reached more than $1,900/oz.  Since then it has crashed back.  It has been down in the $1,100's and currently sits at about $1,200/oz.

You know that part about where the value of a unit of money is supposed to stay relatively constant?  Well, gold has flunked that test.  Any graph of the value of the dollar for the same time period will show some ups and downs.  But they will be extremely modest ups and downs compared to a similar graph of the price of gold.  You have to take money that is not anchored to a commodity on faith.  This makes lots of people uncomfortable.  That's why so many people are drawn to anchoring the value of a dollar to some specific amount of gold or possibly some other commodity.  But, as I demonstrated above, it just doesn't work.  So we are stuck with that uncomfortable feeling whether we like it or not.

Everyone agrees that the goal is to keep the value of the dollar nearly constant.  Economists typically think it is a good idea to keep inflation between say 1% and 2% per year.  That's not constant but it is not a big change either.  And the economy has figured out how to deal with a small amount of inflation, especially if it is pretty predictable.  The inflation rate has stayed within this range in the U.S. (with the exception of a few short term blips) for about 20 years now.   Expectations are that this will continue to be true for at least the next 5 years.  That track record for stability beats any commodity you can think of and it especially beats the track record of gold.

I have been talking about the value of money, specifically the dollar.  Now let me turn to the price of money.  It sounds like pretty much the same thing but it is not.  The price of money is the interest rate you pay to borrow money or receive when you lend money.  Here things get very interesting.

A good working description for how we get high inflation is "too much money chasing too few goods".  Keeping inflation under control is the core goal of the "monetarist" school of economics most notably associated with Milton Friedman.  It also goes by the nicknames "Chicago School" (Freidman was in residence at the University of Chicago for many years) or the "freshwater school" (the University of Chicago is near Lake Michigan, a freshwater Great Lake). In our modern world everything is boiled down to a two sided "black and white" struggle.  This role of "the other guys" is currently filled by Keynesian economists.  Many of them are located on the Atlantic seaboard and the Atlantic Ocean is composed of salt water.  So they constitute the "salt water school".

The Friedman approach is to use the "money supply" to control inflation.  If inflation is too high we fix the "too much money" side of the formula by directly reducing how much money is around.  If we bring the amount of money into balance with the amount of goods inflation should come down.  We monitor the money supply and inflation.  If inflation is too low we increase the money supply.  If inflation is too high we decrease the money supply.  Friedman went as far as to recommend money supply growth targets which he thought would result in a steady and sustainable rate of growth in the economy as a whole coupled with a low rate of inflation.

That's not how it has been done historically.  Historically you didn't control the money supply.  You controlled interest rates.  If inflation is too high you raise interest rates.  High interest rates caused borrowing to dry up which effectively reduced the money supply and got rid of the "too much money" problem.  If inflation was too low you lowered interest rates.  This effectively increased borrowing which increased the money supply and so you had more money chasing the available goods and things would come back in balance.  That was how it was supposed to work.

In about 1970 the supposedly impossible happened.  We had what was then called stagflation.  We had high inflation couple with a stagnant economy (low to non-existent economic growth).  Lowering interest rates was supposed to fix the problem but it didn't.  Keynesians were the group associated with the "control the economy by manipulating interest rates" approach.  When this didn't work they fell out of favor and the monetarists came into vogue.  More recently the crash of 2008 did in monetarists.  Making the recommended change to the money supply did not fix things.  That's why Keynesians are back in favor now.  But as I have pointed out elsewhere (see http://sigma5.blogspot.com/2015/01/metaeconomics-introduction.html) none of the various economic schools work all the time.  So, with all that as background let me get back to my original question:  is the "money market" a market?

And by "money market" I am not talking narrowly about, for instance Money Market Funds.  Instead I am talking about the broad market for money.  And by "market" I mean what I was discussing above.  So we have a commodity, money.  There are all kinds of ways to buy and sell money.  For instance you can make or recoup loans.  You can make or cash out investments.  And there are other ways.  If the market for money is a "market" then we should see the supply and demand for money act as the invisible hand of the marketplace directs.  The price of money should move toward the equilibrium point (a specific interest rate which may change over time).  And if the market for money is out of equilibrium (supply and demand are not in balance) then the  price of money should move toward the equilibrium point.

In fact, everything right now is all messed up.  Interest rates are extremely low.  Every measure says that there is way to much money sloshing around.  That should mean that inflation should be skyrocketing but it isn't.  And with lots of supply around (both lots of money and low interest rates - a low cost of money) people should be falling all over themselves to borrow money, spend, and do all those things that increase the demand for money.  But they are not.  We are at a point that every economic theory says should be impossible.  It should be impossible to have lots of money around while simultaneously having low inflation and low interest rates.  There is no economic theory that says this is possible for any length of time.  But this is the state we have been in since 2008.  That's plenty of time for the "invisible hand of the marketplace" to kick in and start fixing things.

Part of this is understandable.  As I indicated above it is possible to change the interest rate for policy reasons.  It was SOP a few decades ago.  And that's precisely what the Fed has done.  They have driven the short term interest rate (the rate for funds loaned for short periods of time - overnight to a few months at most) to near zero.  That is a traditional lever that has been used in the past to manipulate the economy.  But the Fed has gone far beyond that.  Historically the Fed has only manipulated short term rates.  It was thought impossible for the Fed to directly influence intermediate term rates (roughly 1 - 5 years) or long term rates (roughly 10 - 30 years).  All they could do was jawbone, make ominous pronouncements without any actual power, that were supposed to encourage intermediate and long terms rates to move.  But in the fire of the crash of 2008 the Fed found, created, and in some cases was given more power.  They now have tools (the details are complex and I am not going to go into them) to directly manipulate intermediate and long term rates.  And the Fed has used these tools to force intermediate and long term rates down to historic lows.

So interest rates are where they are due to direct manipulation by the Fed rather than market forces.  Inflation has ended up at a low level, under 2%.  The Fed is supposed to manage the economy to achieve, among other things, a low inflation rate.  But mostly what they have done is notice it is where it is supposed to be.  They have noticed that the other things they are doing have not increased inflation so they have restricted their actions to continuing to keep an eye on it.  But in a low interest rate and a low inflation rate economy economic activity is supposed to take off with a roar.  People with money are supposed to invest.  Buying bonds, for instance is a bad idea because the interest rate is low.  So people should buy things or start companies or that sort of thing.  But they haven't been doing that.

The same is true of corporations.  Corporations have tons of cash and excess borrowing capacity.  With the interest rate for "blue chip" companies (those with very good credit ratings) the interest rate they borrow at is near zero.  So an investment that nets a 3% to 5% rate of return should look really good.  Senior executives are really smart.  We know this because they are paid a lot of money because they are really smart.  So they should have no problem coming up with ideas for investments that yield those kinds of returns.  An idea doesn't have to be very good because those are very low rates of returns.  But corporations have kept their borrowing to a minimum and have not been investing.

Let me say a word about poor and middle class people.  Both of these groups ran up high levels of debt in the run up to the crash of 2008.  So they were caught out when everything went bad.  Since then they have been reducing their levels of debt like mad.  And, since neither group has seen any kind of increase in their income, in fact, frequently it has gone down, it makes sense that these two groups have not been spending or investing in spite of the pro spend/invest climate.  But rich people and corporations were hurt less by the crash and have done very well since.  Both groups have seen income and net worth grow substantially in the interim.  So, unlike poor and middle class people, they have lots of money.  They have just not been parting with it and that has hurt economic growth.

Paul Krugman has noted all this and come up with a suggestion.  In a low interest rate environment it is easy for governments to borrow and spend.  Study after study after study has indicated that our infrastructure, roads, bridges, the power grid, etc., could productively absorb vast quantities of investment.  The construction business has not been busy and there are lots of construction workers around.  There is also lots of excess capacity in the segments of our manufacturing industries that produce the materials like steel and cement that would be used building and repairing infrastructure.  In other words there is not a "too few goods" problem here at the moment.  So now would be a great time to go on an infrastructure spending binge financed by government.  Since no one else is stepping up to the plate, even if you think it is a bad idea for some reason, it is the least worst idea out there for getting the economy moving again.  But Republicans have been continuously blocking this kind of thing since 2011 when they first got into a position where they could.

So the bottom line is that the market for money is not a "market" as defined above because it doesn't behave like one.  We have seen that wheat is a market.  We have seen that utilities are not a market.  And we have seen that money, although not as extreme a case as utilities, is not a market.  Another way to look at the market for money is that it is a deeply flawed market.  It has some market like characteristics but the flaws interfere with market-like behavior.  This view works very well.

It turns out that all markets are flawed.  In the case of wheat the market is flawed but in modest ways.  Crop subsidies and other agricultural programs distort it.  But there are adjustments that can be made so that it generally exhibits "market" behavior.  Utility markets are so deeply flawed that any market-like behavior must be created artificially by regulation.  Historically money has behaved more like a market.  But the amount of distortion and intervention has been so extreme in the period since 2008 that during this entire period it has behaved more like a utility market.

There is an effort underway, it has been ongoing for several years now, to change conditions to a point where enough of the distortion and intervention have been removed that money can again behave in a more market-like way.  It seems to be the goal of everyone, the Fed, its detractors, outside commentators of all stripes, to pull this off.  Various predictions have been made as to when this state can be achieved.  Those estimates have regularly required revision to push the date further out into the future.  Last year people were holding out hope for some time this year (2015).  Now it looks like 2016.  We'll see.

It turns out to be valuable to look at any market and try to spot the flaws.  If we look at Wall Street generally and the market for various kinds of securities a flaw that has been exploited by the "street" as long as the street has existed in the information divide.  Wall Street insiders work hard to be in a position to know a lot more than their customers.  In the run up to the crash of 2008 many Wall Street insiders knew they were dealing in crap investments.  But they told their customers and the ratings agencies that that the investments were high quality.  This allowed Wall Street to sell a lot of crap at high quality prices.  This resulted in tremendous amounts of profits and bonuses.  Before everything fell apart this system was working very well for insiders.  They had every reason to not change it.  And lobbying and campaign contributions were a cheap "cost of doing business" investment in maintaining the status quo.

Oil is another flawed market.  Most obviously many of the biggest players are countries like Saudi Arabia.  The Saudis use the Oil market as an extension of their foreign policy.  They are not alone.  Argentina, Mexico, even the U.S. has at times used Oil to bolster foreign policy objectives.  And I'm not even going to go into all the special Oil related taxes provisions.  Instead ask yourself what happens when the price of Oil changes drastically either up or down.  The wholesale price of a barrel of crude oil has halved from about $100 to about $50 within a period of less than six months recently.  I am old enough to remember more than one "Oil shock" where the price jumped up by large amounts.  In each case where the price moved a lot, either up or down, what happened to demand?  Demand should have shot up a lot when the price dropped recently.  Demand should have shot down a lot as a result of those Oil shocks in the past.

What actually happened was that demand changed very little over the short run (days to weeks and even to months).  That's because the kinds of changes that would move demand for Oil are not possible to do quickly.  You still drive back and forth to work regardless of whether Oil is cheap or expensive.  You still have errands to run, a home to heat, etc.  You can cut back a little if the price goes up or increase your consumption a little if the price goes down.  But these changes move demand for oil by at most a few percent.  Over time you can get a big car/truck that gets terrible gas mileage or go on more and longer vacation trips if the price drops.  Or you can buy an econo-car or sell your motor home if the price goes up.  You can even change your house from Oil heat to Gas heat.  But these changes take years.  So when viewed over a time frame of years Oil behaves somewhat like a market.  It does not when viewed for short intervals.

I used to work for a dairy.  The price we bought raw milk from dairy farmers at was set by a complex formula based on the price of milk on a small exchange in Minnesota.  Only a tiny percentage of milk produced in the country was traded on that exchange.  But it was the only milk exchange in the country.  So that's what got used.  The price we sold the products we made from that raw milk, 2% milk or butter or whatever, in the supermarket for was much more based on the usual market forces.  It made the financial management of the business very complex.

Then there's the issue of social benefit.  A market achieves a purpose.  The question is:  does it achieve the right purpose?  In many cases the right purpose may be low price and plentiful availability.  Most people would be happy to characterize the wheat market that way.  But consider Oil.  Oil consumption generates greenhouse gases which contribute to global warming.  You may say "I don't care.  I want the benefits Oil brings me and I am a Climate Change denier".  OK.  This is consistent with the Republican/Conservative position that markets solve all problems and deregulated markets solve them best.  But how about abortions?  An unregulated abortion market would make them cheap and widely available.  That's all to the good, right?

Republicans and Conservatives think that cheap and widely available abortions would serve the wrong purpose.  So what do they do?  The do what they can to make abortions expensive and difficult to obtain.  And one way to do this is to pile on the regulations.  I am not trying to get into a big political fight here.  I picked a pair of markets that were important to Republicans/Conservatives because I wanted to show that even someone who generally favors market based solutions and deregulation finds that for social benefit reasons the right thing is to do the opposite.

It would be easy to find a similar pair of markets where Democrats/Liberals would similarly find themselves in favor of a market based low regulation market  even though they are more suspicious of markets and generally more in favor of regulation.  In other words, they would favor the Republican/Conservative approach.  And of course with the other market they would favor a non-market based solution and/or more regulation, a position more in line with their general philosophy.  It doesn't matter what your belief system is you are going to end up on one side of the argument in some cases and the other side of the argument in others.  In other words, social benefit is important to all of us.  It makes sense for people to disagree on what is the appropriate social benefit to aim for.  It does not make sense to argue that social benefit should not be taken into consideration.

Every market has flaws.  Some are serious.  Some are not.  In some cases there is general agreement on what flaws a market has and how serious they are.  Where there is a disagreement on the social benefit of a particular market there will likely be a disagreement on the degree and type of flaw associated with that market.  The flaws found in many markets require some kind of intervention, typically regulation.  Wall Street must be forced by regulators to be honest and transparent with its customers.  (Others may disagree but I think the crash of 2008 speaks loudly in favor of my position.)  The wholesale milk market is already highly regulated and frankly the dairy business would not exist without these regulations.  As a result of this consensus there is no push to deregulate.  And so it goes.

Politicians, currently mostly Republicans, are the great champions of markets, and in particular unregulated markets, as the solution for everything, except of course when they are not.  It is dishonest to claim to always be in favor of (or opposed to) unregulated markets.  It is also dishonest to claim that social benefit analysis does not figure into things.  Everyone takes social benefit into account either consciously or unconsciously.  Being unwilling to admit that this is so is just a way of lying to yourself.    

Metaeconomics - The Panic of '08

In my last post I introduced the concept of Metaeconomics.  Microeconomics is the study of the individual.  Macroeconomics is the study of groups.  Metaecomics is the study of the system as a whole.

So why do I call it the "Panic" of '08?  In the 1800's, before the establishment of our modern banking system anchored by the Federal Reserve Bank, there was an event that happened about every ten years.  Out of nowhere, it would seem, a number of people would all of a sudden become concerned about the financial stability of a bank.  They would rush to take their money out "in a panic".  This is called a "run on the bank".  This very action would result in the event the people feared.  The bank run would force a bank out of business and investors and depositors would lose all or a large part of their money.  One bank run would result in one bank failure.  But once one bank failed due to a run people would become concerned that other banks were vulnerable.  This would result in other runs and other failures.  And so on.  Often many backs would be sucked in before things subsided.  And after the bank failed each bank's books would be gone over.  It turns out that in a lot of cases the bank was perfectly sound.  If there had not been a run there would not have been a failure and there was really no reason for the run in the first place.  But people had panicked.  And that became the nickname for these events, "bank panics".

Once a panic had gotten started and had gone on for a while the phenomenon would burn itself out and things would settle down and return more or less to normal.  Of course a lot of people would have been "wiped out".  As I said, a panic that was big enough to involve enough banks to attract widespread notice would take place about every 10 years.  So after a few panics pretty much everyone knew how they worked.  This put people on "hair trigger alert" and they would start a run at the slightest pretext "just to be on the safe side".  Panics were horrible and they did great damage to the economy.  Eventually the "Fed", the Federal Reserve Bank System, was put into place.  And in the Great Depression the Federal Deposit Insurance Corporation was also put into place to insure deposits held in federally chartered banks.  The combination of the Fed and the FDIC was supposed to do away with panics.  You wouldn't be wiped out because your deposits were insured by an arm of the Federal Government.  So there was no longer a reason to panic and participate in a run on the bank.  And for many decades the system worked.  But the events of '08 bear a striking resemblance to a nineteenth century bank panic so that's the term I am going to use.

So that's one digression.  I am now going to go on a second digression and discuss cascading failure.  Then I will get back on track and take a look at the Panic of '08 from a Macroeconomic perspective.  Finally, I will tie it all together by moving to a Metaeconomic perspective and applying what we learned about cascading failure to the events of '07-08.  You've now been warned.

Cascading failure

Let's take a look at our national electric power grid.  We are going to do a very shallow dive so don't panic.  When looking at complicated interconnected systems engineers talk about sources and sinks.  The places where the power comes from are called sources and the places the power goes to are called sinks.  In the case of the "grid" the sources consist of power generating stations, things like hydroelectric dams and power plants.  The power plants can be fueled by coal, natural gas, nuclear power, wind, whatever.  It doesn't matter.  If it produces power it's a source.  Sinks also come in lots of flavors.  They can be small sinks like houses or large sinks like chemical plants, other large manufacturing facilities (airplane manufacturing facilities are popular in my part of the country), anything that uses a lot of power.  Or they can be somewhere in the middle, things like office buildings or apartments.  If it consumes power it's a sink.  Then connecting everything together we have "power distribution" lines.  These are specialized wires that move power from one place to another.  All these parts are connected together by specialized facilities called "distribution yards".  And that's all the technical detail we need to be familiar with.

Now, let's assume that for whatever reason lots of power is being used right now.  That means that the sources are cranked up putting out lots of power and the distribution lines are moving lots of power from one place to another.  Now let's say something goes wrong.  Say a power distribution line gets overloaded and "trips out".  Or let's say something breaks in a distribution yard and it trips out.  Why do I say "trips out"?  Because there are circuit breakers all over the place.  If a circuit breaker detects that too much power is moving through it then the "trip" mechanism kicks in and the breaker "trips out".  The thing that goes wrong can even be a breaker tripping out when it shouldn't.  Anyhow, something goes wrong.  What happens?

Electricity behaves a lot like water.  If it can't go this way it goes that way.  So if a distribution line trips out the electric load instantly switches to any other distribution lines that are still hooked in.  If part of a distribution yard trips out the electric load instantly switches to the other parts of the yard or it finds distribution lines and goes to another yard.  This actually does not happen instantly but it happens pretty quickly.  A second is a long time for electricity.  So now the load has just been increased in other parts of the power distribution system.  What happens?  And the answer is "it depends".

It depends on how much load the components now have to handle.  If the component was lightly loaded before then it will be able to handle the new added load.  So nothing will happen.  No one other than the people who monitor the grid will even know something has happened.  But remember we said lots of power is being used right now.  That means that the affected components are probably running at or near capacity.  The additional load will most likely put them into overload.  The overload will cause circuit breakers to trip out.  The electric load will instantly try to find a new path.  This will most likely cause more components to overload and more circuit breakers to trip out.  This will keep going much like the bank panics used to spread in the 1800's.  Eventually the failures will spread to parts of the grid that are not running at high capacity.  Or grid operators will manually trip breakers to break connections between one part of the grid and others.

We have had a number of these wide spread outages over the years.  They happen in the northeast more often than in other parts of the country because a lot of population and industry is concentrated there.  But, depending on the size, they happen everywhere.  Relatively small ones happen every time we have bad weather, blizzard, hurricane, whatever.  They all start out as a small problem.  Typically one component that is not supposed to trips out.  This causes other components to overload and trip out.  The problem then "cascades" from one component to the next to the next as component after component overloads and trips out.  Hence the name, cascading failure.

To have a cascading failure you need a lot of components connected tightly together and dependent on each other.  A lot of systems have this characteristic.  So how do you avoid cascading failures?  You build in more capacity than you need under normal circumstances.  Bridges and airplanes, for instance, can and sometimes do suffer cascading failures.  Engineers know this.  So they build each component stronger than it needs to be to handle the load it is supposed to carry.  So if a part of a bridge or airplane fails what is supposed to happen is that the other components have enough reserve strength to handle the additional load.  If this happens the plane keeps flying and the bridge stays up.  But sometime the new load is too much or, for whatever reason, the other components are not as strong as they should be (they may have become corroded over time, for instance).  Then we have a cascading failure and the plane crashes or the bridge falls down.  That's cascading failure.  Now let's get back to the Panic of '08.

Macroeconomic analysis of the Panic of '08

Let's begin at the beginning and that's with the Mortgage market.  And let's do a standard macroeconomic analysis.  Above I talked about panics.  They were an all too well understood phenomenon in the 1800's and the early part of the 1900's.  Then we fixed the problem and people started forgetting about them.  I want to now talk about another well understood phenomenon.  But in this case we haven't forgotten about it.  That is the "bubble".  The bible on bubbles was written in 1841 by Charles Mackay.  I alluded to it in an earlier post (http://sigma5.blogspot.com/2014/07/tech-bubble-20.html).  Unlike panics, bubbles, even though they have been with for even longer than panics, have not been forgotten about.  And the mortgage market was a classic bubble.

Bubbles are a phenomena of markets.  So you need a market.  Was the mortgage market a market?  Yes!  Check.  Next, bubbles go through stages.  The first stage is the pre-bubble stage.  This is the period in which the market behaves normally.  We can check off this requirement off too.  In stage two there is the "clean run up".  This is the stage where, for whatever reason, our market goes straight up.  There are no "corrections" where the market goes down (or the corrections are small and short lived so everybody pretends they didn't happen).  This is the "prep" stage.  Again, this stage was present in the mortgage business.  The next stage is the first stage that is part of the true bubble.  In stage three people start telling themselves and others "this market can only go up and it can keep doing it forever".  Check here too.

In stage four people start saying "this has gone on too long - we are overdue for a correction".  In spite of this the market continues to go up.  This is sometimes referred to as "climbing a wall of worry".  Not to put too fine a point on it but definitely check.  Stage five is similar to the start of the panic or the cascading failure.  Something happens and the market (or at least part of it) goes down.  People notice this and say "it's just a blip - stay in the market".  Initially it is not obvious whether this actually is a blip (see stage two) or whether it is more serious.  Often this stage is of very short duration.  Stage six is when people go into panic mode and start dumping in large volumes.  The people who are early to this stage do just fine.  But prices move down at a speed indistinguishable from instantaneous and lots of people take a big bath.  Finally, after a large amount of carnage, things settle down and we go back to the pre-bubble stage.

So the mortgage market was a classic bubble.  Standard macroeconomic analysis would pick that up and, if we stick narrowly to the mortgage market, standard macroeconomic analysis would have done a good job of giving us an accurate picture of what was going on.  But a lot of attention has focused elsewhere.  There was a lot of fraud and bad behavior involved in the mortgage market.  The fraud consisted of putting people in bad (high interest) mortgages when they qualified for good (lower interest) one.  The bad behavior consisted in "no doc" and other gimmicks to get people into mortgages that they couldn't afford.  It is only "bad behavior" because it was all legal.

Both of these activities had an effect.  They made a bad situation worse.  But you could have had a mortgage bubble even if both were absent.  It might have taken longer to form and it might have been smaller.  But neither action affected whether the mortgage market was a bubble or not.  And the bubble nature of the mortgage market was what did the economic damage.  From a policy point of view and from a humanity point of view both activities should be stopped.  But from an economic point of view neither was very important, except to the people directly involved.  If we do a microeconomic analysis of these people they were horribly harmed.

The next link in the chain was Wall Street.  Wall Street bought these mortgages.  In fact the crappier the mortgage the more Wall Street wanted it.  Why?  Because crappy mortgages came with higher interest rates than good mortgages.  And a high interest rate connected to a "safe" investment was catnip Wall Street was drawn to.  They were so strongly drawn to crap mortgages that they told the mortgage market "bring us more crap".  If you are trying to sell an investment and the customer has two to chose from what will the customer do?  In this case both investments are rated AAA (safer than Fort Knox) but one of them pays 6% and the other pays 8 1/2%.  Would you rather be selling the 6% investment or the 8 1/2% investment?  Thought so!  The problem here was that Wall Street convinced itself (at least that's what they say when testifying under oath) and the customers that both investments were AAA.  In reality the 8 1/2% investment was crap and, in a lot of cases, the 6% investment was crap too.

A traditional macroeconomic analysis of the mortgage market in Wall Street would not have shown up any problems.  If the investments has actually been AAA then everything would have been fine.  But they weren't and that's something macroeconomic analysis is incapable of picking up on.  And, given Wall Street's ravenous appetite for crap mortgages, it is not exactly a surprise that the mortgage industry found very creative (sometimes legal and sometimes not) ways of manufacturing crap mortgages in large numbers.  Crap mortgages generated higher "loan origination" fees so mortgage brokers were happy to do what they could to manufacture more.  The "incentive structure" in the business encouraged them and they responded to that encouragement just like all the models said they would.  So for about five years we got a lot of crap mortgages created.

The next link in the chain (link three, if you are keeping track) was also housed on Wall Street.  Why was Wall Street's appetite for crap mortgages so voracious?  Because they had invented something called Collateralized Debt Obligations, CDOs for short.  The whole process is complex.  When you have a bunch of the "smartest guys in the world" (their characterization of themselves) testifying under oath that they didn't really understand CDOs I think we can take it as a given that they were complex.  And part of this complexity was deliberately created to avoid people (regulators, the business press, elected officials, the public) catching on to what was going on.  I have read a number of books that have covered this sort of thing.  I think I have a pretty good idea what the real story was but I am going to just focus on one thing "tranches".

And I am not going into tranches in detail so you can relax.  I am just going to hit a couple of highlights.  Wall Street would buy up a bunch of mortgages (thousands) and dump them all into a single CDO.  So how does that help?  So far it doesn't but that's where tranches come in.  Wall Street would effectively (the actual details are complex and we don't need them) partition the mortgages in the CDO into buckets called tranches.  Why tranches?  I don't know.  I would guess because "tranche" sounds cool and vaguely foreign whereas "bucket" sounds dull and boring.  Anyhow, what the tranche system did was allow Wall Street to sell parts of the CDO.  They put all the high risk stuff into one bucket.  That made all the rest of the stuff low risk.  If the tranche trick was done well almost all of the CDO became AAA.  They would hide the bad stuff away rather than trying to sell it.  They made so much money selling the good stuff that they could afford to take a bath on the bad stuff.

Now if this is sounding like it wouldn't work, you're right.  But what's going on is I am saving you from a bunch of details.  They didn't actually put each mortgage in the CDO into a specific tranche.  What they did was wait.  If a mortgage went bad they retroactively put it in the "bad" tranche.  From an investor point of view, this worked great.  Wall Street could almost guarantee that the stuff in the tranche you bought would never go bad.  And a lot of buyers skipped over the "almost" and took what they heard as a guarantee.  No one took a bath until every single mortgage in the "bad" tranche went bad.  And that was never going to happen.  Why?  Because it never had happened before (or so said Wall Street).  This whole "tranche" business was how Wall Street, with a little help (see below) was able to manufacture all these AAA investments with high interest rates.  The whole system worked great, until it didn't.  Like link two, all this tranche business was invisible to standard macroanalysis so economists missed it.

Link four rests with the ratings agencies.  There are three big organizations and a couple of small ones.  I'm going to ignore the small ones.  Their job is to do the work on behalf of investors of figuring out just how risky an investment is.  Each agency has slightly different criteria and uses slightly different rules.  But generally speaking a low letter in the alphabet is good where a high letter is bad.  So "A" is best.  But they each subdivide "A" into subcategories.  How they do the subdivision also varies.  But "AAA" has become synonymous with "the best of the best".  Each agency has a rating that is or is equivalent to AAA.  Generally speaking any kind of "A" or "B" rating is considered "investment grade".  Higher letters indicate "less than investment grade" and each agency has a grade that is equivalent to a report card grade of "F".  Securities with this grade are generally referred to as "junk".

Not all junk investments fail and some AAA investments fail so the ratings are not foolproof.  But they are supposed to be pretty good.  An AAA rated investment failing is supposed to be like being hit by lightning.  It happens but it is pretty rare.  And there are funds that invest in junk.  Lots of junk eventually pays off.  In the mean time it usually has a very high interest rate associated with it.  Junk funds bet they can keep their failure rate low enough so that the high interest rate more than covers the losses.  That's probably too much information so let me move on.

The ratings agencies rated a lot of investments AAA that were eventually found to be junk.  A lot of investors are required by laws or regulations to only by "investment grade" securities.  So if your security is not investment grade your pool of potential customers shrinks a lot.  So in most cases it is critical that a security get an "investment grade" rating from the agency that rates it.  And, of course, everybody loves an AAA investment with a high interest rate attached.

Now one fly in the ointment is that the company creating the investment picks the agency that ends uprating it.  The agencies know that so a big priority is to keep Wall Street happy.  And the way you do this is by coming up with a lot of AAA ratings.  The only trick is to do this while maintaining a reputation for doing your work properly.  The way to thread this needle is to rely on something called "due diligence".  This is the standard process for performing a rating.  If you rate something AAA and it turns to junk it helps if you can say "I did my due diligence but the security turned to junk so it must have been for reasons beyond my control".  And, frankly for several years the whole thing worked fine.  The AAA stuff paid just like it was supposed to.  In other words, it behaved like AAA securities are supposed to behave.  Then one day all these AAA securities turned to junk pretty much instantaneously.

So what went wrong?  Isn't the "due diligence" process supposed to look in all the nooks and crannies where future bad news may be lurking?  It is.  But these CDOs were a new thing.  There was no history going back decades to consult when looking for ways they could go wrong.  And remember that one of their attributes was that they were wicked complex.  Now a simple response to this would be to say "these are too new and too complex to rate them AAA".  But if a ratings agency did that then Wall Street would just go down the street to another agency.  As long as one agency was willing to look the other way they were all stuck coming up with a rating anyhow, that or go out of business.  None of them were willing to go out of business.

So what did they do?  First, they held their noses and completely ignored the "too new" problem.  As for the "too complex" problem they went along with the Wall Street solution.  Wall Street had come up with a marvelous computer program.  You put a bunch of data in and out popped a single "risk" number.  If the program popped out a number that translated to "low risk" then the agency said "we're good here" and gave it an AAA rating.

Standard macroeconomic analysis might have been able to turn up the "screwed up incentives" problem, the fact that the issuer selected the ratings agency and paid the fee.  But the "no history" problem and the "too complex" problem were of the type that macroeconomics can't detect.  And let me drill down on the ratings program a little more.

The program was developed by a good mathematician.  In theory there was nothing wrong with it if it was used properly.  But Wall Street immediately threw out the "if it was used properly" part.  The details of how the program worked are very complex but we don't need to go into that.  We can just focus on how you used it.  What you did was pour in a bunch of historical data.  This security had this set of attributes and it went bad.  This other security had a different set of attributes and it paid off just fine.  That sort of thing.  Then, after you had loaded up all the historical data you loaded up the details of the investment you wanted to rate.  The program would churn for a while trying to match up the historical stuff with the stuff for the investment you wanted to rate and pop out a number.  If you think about it for a minute you should see how to game the program to get the result you want.

What the program knows about outcomes depends completely on the historical data you pour in.  If you pour in a lot of historical data covering a lot of situations then the program can do a good job.  But what if you pour in a very limited amount of historical data.  And what if all the historical data you pour in represents situations where only good things happen.  In this latter case it is hard to blame the program for getting it wrong.  There is an old saw in the computer business:  "garbage in - garbage out".  It should come as no surprise to learn that Wall Street poured in only the finest sweet smelling garbage.  So the program would look at the security it was rating and decide that it smelled pretty sweet too.  The ratings agencies should have figured out what Wall Street was up to.  But the only one that seems to have figure this out is Wired Magazine.  They did a nice story outing all this and more.  There was exactly zero follow up.  Neither the mainstream media nor the financial media picked up on the Wired revelation and ran with it.  So this shenanigan plays no part in the story most people tell about why things went wrong.

Let's move on to link five.  It is in some ways the most interesting.  There are lots of mortgage brokers.  There are fewer but there are still many players on Wall Street.  There are only three big ratings agencies.  But still, three is more than one.  Link five is all about just one company, AIG.  AIG is an insurance company.  AIG sells (or at least sold) many lines of insurance.  You can get car insurance or boar insurance or life insurance from AIG.  If you are an airline you can (or at least you used to be able to) lease an airplane from AIG.  But all we are concerned about is one of the many subsidiaries of AIG.  And there are lots of insurance companies out there.  And they sell lots of kinds of insurance.  But this one subsidiary of AIG pretty much locked up the market for a specific kind of insurance.  This kind of insurance is called a Credit Default Swap or CDS.  The key word in CDS is the middle one, "default".  The "CDS insurance" subsidiary of AIG sold a policy that paid off if you bought a security and it defaulted (went bad).

Now if we are talking about junk bonds the chance of default is significant.  That's what makes it junk.  But what if we are talking about "safer than Fort Knox" AAA stuff?  Then we are talking maybe one in a thousand, just to be safe.  So let's say I want to buy a CDS on an AAA security.  How much should I have to pay for it.  Well, if I am AIG and I compute the chance is 1 in 1000 then how about I charge 1 500th of the value of the security.  That's 0.2% of the face value of the security.  If the security has a face value of 1 million dollars then the fee would be $2,000.  That sounds pretty cheap.  And remember, the chances of the security actually defaulting (or so everybody thinks) is probably more like one in 10,000 so the expected profit margin for AIG is better than 50%.  It's a perfectly legal low risk "double your money" scheme.

And by marketing aggressively and getting in early AIG locked up most of the market.  Sure, you didn't make that much money on each transaction.  But it was the McDonalds model:  Sell a lot and even if you don't make much on each one you will do fine when you add it all up at the end of the year.  And AIG did.  They made massive profits in this little division for year after year.  Everyone else wanted to get a piece of the action but AIG managed to hold on to it.  And then, of course, everything went south all at once.

These "one in a thousand" shots turned into "one in ten" shots.  All of a sudden charging 0.2% for CDS insurance looked really stupid.  Now AIG was a really big company.  But it had sold a freakishly large number of these CDS deals.  The amount AIG was on the hook for was, in round numbers, a gazillion dollars.  AIG had a lot of money but it didn't have nearly enough money to pay off all the CDS bets that all of a sudden went wrong.  Let's leave AIG aside for a minute and look at the people who bought CDSs.

They did it for a number of reasons.  In some cases they were risk averse.  For a mere $2,000 you could turn a very small chance of losing a million dollars into zero chance of losing a million dollars.  That sounded like a good deal to a lot of careful investors.  In other cases an investment might look risky to a ratings agency.  If you spent $2,000 (chump change on Wall Street) you could say to a ratings agency "say you are right and this is a risky investment.  We just bought CDS insurance.  So if the investment goes bad the insurance company pays off.  So give us our AAA rating".  And the ratings agency did.  Another situation was what is called arbitrage.  Let's say you can buy gold in London for $1,000/oz. (I am using unrealistic but easy to deal with numbers so you can understand what's going on).  Now let's say you can buy gold for $1,020 on the Chicago Mercantile Exchange.  And let's say you have a lot of money.  Well you buy 10,000 oz. in London and sell 10,000 oz. in Chicago.  That should allow you to clear $200,000, risk free.  You can use the gold you bought in London to cover the gold you sold in Chicago.  This process is called arbitrage.  You find two markets for the same thing.  You look for price differences between the two markets.  You buy in the cheap market and match it with a sale for the same amount in the expensive market.  If you can pull it off it is theoretically a license to print money.

If you are going to get in the arbitrage market you want to look for all the ways things can go wrong.  And sometimes you can buy insurance cheap enough so that you can eliminate one or more ways things can go wrong.  So people in the "arb" game often found it appropriate to buy CDS insurance.  And all these people buying CDS insurance for various reasons is why it was a wonderful business for AIG to be in until it wasn't.  It quickly became apparent that AIG couldn't cover its losses.  That meant that some very large and important companies all of sudden stood to lose giant amounts of money.  And in many cases losing that much money would immediately put them out of business.

And here's the point where it make sense to circle back to this whole idea of cascading failure.  The companies that were caught out by the whole AIG CDS fiasco did a lot of business with other companies.  If they went under, and especially if they went under essentially instantaneously and quite unexpectedly, it quickly became apparent that they would take these other "innocent bystander" (at least in many cases) companies down with them.  These, in turn, could take down more, and those more, in a classic cascading failure scenario.  And that's why the Fed found a way to bail AIG out.  At this point it should come as no surprise to learn that a standard macroeconomic analysis of the CDS market or of AIG would not turn the problem up.

Before moving more firmly on to my metaeconomic analysis let me make one more observation about AIG.  AIG is (or at least was) a U.S. company.  Sure it did business around the world but that's a detail.  Except it is not.  Do you know where the CDS division was located?  London.  Why?  The insurance laws in the U.K. are different than they are in the U.S.  AIG would have had all kinds of reserve requirements, capital adequacy requirements, requirements to maintain certain ratios above or below certain numbers, etc.  AIG could not have operated the CDS business the way it wanted to in the U.S.  The U.K. requirements were quite a bit looser and what it was doing was perfectly legal in London.  You can wire vast quantities of money anywhere in the world in less than a second.  So it did not make it any harder for AIG to do business from London than it would have from Hartford (Connecticut Insurance rules) or in Wilmington (Delaware Insurance rules) or any other "business friendly" state.  But London was the friendliest of them all so London was where they did business.  This is a classic example of "regulator shopping" that I have remarked on elsewhere).

Metaeconomic Analysis of the Panic of '08

Traditional analysis said that the mortgage segment was not big enough to take the entire economy down or even Wall Street.  And if it wasn't for the linkages this would have been true.  But it was tightly linked to Wall Street.  So it could and did cascade the failure.  And thorough CDOs Wall Street was able to cascade the failure all across the U.S.  In fact, in an area that I skipped over, CDOs cascaded the failure to encompass the entire world economy.  A contributing factor to Wall Street's ability to sell CDOs was the behavior of the ratings agencies.  Then there was the link represented by AIG and CDS insurance.  The failure immediately took AIG down.  But in taking AIG down the failure, had the Fed not stepped in, would have cascaded out to individuals and companies all across the country and around the world.

And, in another area I have skipped over, by 2008 big banks were heavily invested in the mortgage market.  So the crashing of the mortgage market put these big banks into serious trouble.  Theoretically Joe public was protected by FDIC insurance.  But at the time FDIC insurance only covered the first $100,000.  Few individuals had that kind of money in a checking account.  But many people had that much in "jumbo" CDs.  And many small businesses and every medium or large business had accounts with balances well over $100,000.  If these big banks had gone under then the impact would have been great.  And by this time the FDIC has managed a number of bank problems in such a way that people with high balances were completely covered.  This had translated to an expectation that money in accounts at Federally Insured banks was 100% safe regardless of the balance.  As a result of '08 panic the FDIC temporarily and later permanently raised the insurance limit to $250,000.  But mostly, one way or the other the government bailed out all the big banks.

And there turned out to be more linkages.  Before '08 there were two kinds of banks, "commercial" banks and "investment" banks.  Commercial banks were covered by FDIC Insurance and (theoretically) restricted as to the kinds of business they could engage in.  Investment banks were not insured and could go full "wild west" if they wanted to.  But it turns out that a surprising number of different types did business with the investment banks.  By the time the crisis played out the government was required to find a way to pull investment banks into the FDIC/Fed fold and bail them out.  Any doubt about this was removed when Lehman Brothers, a classic investment bank, was allowed to go under and all Hell broke loose.  Before Lehman an argument was made, and lots of people believed it, that investment banks could and should be allowed to go under if they misbehaved.  This experience hatched the phrase "Systemically Important Institutions".  In plain English it means "too big to fail".  The government can't allow the institution to fail without crashing the economy.

Metaeconomic analysis turns up several threads.  The most obvious one is that the economy is subject to cascading failures.  Most older economic analysis assumed that segments of the market were independent.  And, more than that, they assumed that they were both internally independent and externally independent.  Let me use mortgages as an example.  By internally independent I mean that the performance of one mortgage was not tied to the performance of other mortgages.  But it turned out that forces that operated at the level of the entire U.S. economy propped up mortgages (prices were going up everywhere so you could always exit a mortgage cleanly by selling the house) then they drove down mortgages (high default rates everywhere due to the '08 Panic drove home values down everywhere causing mortgages everywhere to go under water at the same time).  So mortgages were not internally independent.  By externally independent I mean that a downturn in the mortgage market could cause an economic dip but it would not completely crash other parts of the economy.  But we see that the mortgage market turned out to be tightly linked to Wall Street and down stream linkages tied the mortgage market to the entire world economy. This degree of linkage was literally unimaginable before the Panic of '08.

This means that the standard engineering technique of excess capacity need to be applied broadly to many segments of the economy.  For physical structures like airplanes and bridges it means making every component stronger than they need to be to support calculated loads.  How does this translate into economic terms.  In most cases it means reserves.  In the old days a perspective home owner needed to put 20% down before he got a mortgage.  This meant that even if the mortgage went under there was a lot of money available to cover costs like fees and perhaps a dip in the value of the house before the mortgage issuer lost money.  A home owner with a 20% down mortgage has 5-1 leverage.  For every five dollars the mortgage issuer puts out the home owner has put out one.  A lot of Wall Street was running at 50-1 leverage.  This means that if an investment loses 2% of its value the Wall Street firm is in the red.  This gives the Wall Street firm almost no ability to ride through a dip.  Everything must go up and stay up or the firm quickly gets into trouble.  AIG had leverage along the lines of 500-1.  Given that it is no surprise that they got into trouble as soon as the market turned.

The high degree of linkage we now can see means that each of these segments needs significant excess capacity.  The Panic of '08 demonstrates that segment after segment after segment lacks sufficient excess capacity.  It would be nice if we can look at what has happened since '08 and see excess capacity being added broadly.  But mostly we don't.

Another thread I did not get into above is what I call the political problem.  Most regulation is done by the government.  Governments are by their nature political.  That means that they are buffeted by political winds and respond to the political pressures applied.  Sporadically before and definitely during the Great Depression political pressure said "things are out of control - they need to be reigned in".  This resulted in a lot of regulation being put in place.  In general the regulation worked.  Our economy was stable from the '30s through the '60s.  Then the economy suffered some shocks.  There was the "stagflation" of the Nixon era.  Then there were the shocks caused by large increases in the price of Oil and other forms of energy.  This resulted in a political argument being advanced that "the problem is regulation".  The political response was deregulation.  The effort was first applied in the  transportation industry.  Regulations were lifted covering pricing and routes in the airlines and the long haul trucking business.  This was generally viewed as a success.  Airplane tickets got cheaper and the cost of trucking goods around the country dropped.  This deregulation trend has continued ever since, at least to '08.

Other deregulation initiatives were undertaken.  Some seemed to work out ok.  Other didn't.  Savings and Loan institutions were deregulated in the '80s.  This resulted in the "Savings and Loan Crisis" of the late '80s and early '90s.  The government had to step in and bail out S&Ls as over a thousand of them went bankrupt.  One big initiative was Wall Street deregulation.  This was coupled with a cry to "get the regulators off Wall Street's back".  The Glass-Steagall act that limited the kinds of business commercial banks could transact was repealed in the late '90s, for instance.  Utilities regulation and oversight was scaled back too  The combination of Wall Street deregulation and utility market deregulation resulted in the Enron Scandal.  Enron rigged various wholesale electricity markets and engaged on other examples of outrageous behavior.  But this bad behavior was not enough to keep it afloat.  When it went under various accounting bad behavior was exposed along the way.  This resulted in the passage of a law called Sarbanes-Oxley" or Sox, for short.  Many, including myself thought that Sox didn't go far enough.  But Wall Street immediately mounted an extensive lobbying effort to "roll back" Sox.

And then the Panic of '08 happened.  This has hatched, among other things a piece of legislation called Dodd-Frank.  Again, if anything it didn't go far enough.  But efforts are already under way to roll it back.  Another initiative is the Consumer Finance Protection Bureau, an initiative championed by now Senator Elizabeth Warren.  It's job is to protect consumers from predatory practices by lenders.  Its efforts to reign in the most egregious practices by credit card issuers, "payday loan" lenders, and others is being vigorously opposed by the companies that see, quite rightly, that their ability to pull in large profits is being restricted by this bureau.  No one disputes that before CFPB these practices were entirely legal.  The question is not whether they were legal.  The question is "should they continue to be legal going forward".

There is such a thing as a "captured agency".  This is an agency that is supposed to regulate and monitor an industry.  But only that industry much cares what it does.  Through lobbying and other political efforts an industry can capture an agency.  They turn an agency's mission from doing what it should be doing to doing what the industry wants it to do.  Money and finance businesses have waged a long and successful effort to capture the agencies that are supposed to be regulating and monitoring them.

Almost no one pays enough attention to figure this out.  For the most part our print and broadcast media are now owned by large companies.  They want their "news" operations to be financially successful and think this can be done while they simultaneously do not "speak truth to power" if the power is a business power.  Just look at how vigorously the media chases sensationalism by concentrating on fire trucks, sports, and celebrities.  The mantra from the Watergate era was "follow the money".  But if you look, the money in politics is almost never followed in anything but the most superficial way.  As a result, I am pessimistic that turning toward a more pro-regulatory attitude is in the cards.  But a metaeconomic perspective indicates that it is one of the most important steps we can take to avoid a future panic.

A final observation.  The above is pretty pessimistic.  And it is in line with what most observers I trust think.  But there is a ray of hope that is missing from their prognostications.  That is the "sucker factor".  P. T. Barnum is said to have opined at one point that "there's a sucker born every minute".  If he said it then he would have said it in the late 1800's, roughly 150 years ago.  In any case the sentiment has been with us for a long time.  And before the Panic of '08 it was definitely applicable to people who bought CDOs that later turned into crap.  Before '08 these people believed Wall Street sales people who said "we are working on your behalf".  They also believed ratings agencies who said a security was "safer than Fort Knox" (i.e. AAA or equivalent).

The number of people who now naively believe these kinds of representations has diminished substantially.  Wall Street and the ratings agencies have a credibility problem.  They will continue to have a credibility problem as long as the people they victimized are still around.  And I hope that the generations of people that follow are also trained to bring a boatload of skepticism to the table when dealing with Wall Street.  At the moment people are in "trust but verify" mode when they are dealing with Wall Street.  As long as that continues to be the case our chances of avoiding another panic are considerably better than they otherwise would be.  That is grounds for optimism. 

Metaeconomics - An Introduction

This is a subject I intend to return to repeatedly.  This specific post is intended to create and promote a particular definition for a term.  "Metaeconomics" is not a new term.  But a Google search only yields 8,520 hits.  That is a pathetically small number.  Try to enter any search term into Google and get less than 10,000 hits.   And, as commonly happens, most of those "hits" are off point.  Only the first nine hits are on point.  So what do I have in mind?

Back while I was in college I took the usual "Introduction to Economics" class.  In that class I was introduced to the terms "microeconomics" and "macroeconomics".  Little has changed since the late '60s when I took the class.  Those terms are still in common use.  For the purposes of this piece I define microeconomics as the economics of the individual and macroeconomics as the economics of groups.  They are presumably connected by the fact that groups of individuals, each acting as microeconomics predicts, will, when aggregated into a group, cause the group as a whole to behave in the manner macroeconomics predicts.

Now many would disagree with these definitions and their complaints would be legitimate.  But I am going to ignore them anyhow.  Instead I am going to make an observation, actually a chain of observations.  We had in 2007-2008 an economic event of epic proportions.  Yet it was not predicted by anyone.  Specifically, it was not predicted by any economist.  That's bad.  I have now read many books on the subject.  Some were written by economists and some by others.  Several of them just attempted to provide a narrative of what happened.  But a number of them, after doing a nice job on the "what happened" part of the story, tried to then move on to the "why" part of the story.  And a few moved finally to "what should be done".

I want to point out one specific book in particular.  "The Shifts and the Shocks" is by Martin Wolf.  Wolf is a long time and well respected writer for the Financial Times.  Roughly speaking, the FT is the British equivalent of The Wall Street Journal.  Wolf is not a professional economist but he is thoroughly familiar with the work of professional economists.  And he is a long time observer of the financial scene.  And he does the "what happened" part followed by the "why" part followed by the "what should we do" part as well as anyone.  Like others I would score him as doing an excellent job on "what happened", a pretty good job on "why", and a terrible job on "what we should do.  Now back to economics.

Attempts to explain and understand the economic actions of groups falls into the "macroeconomics" bucket.  But it does a poor job.  Macroeconomics does a pretty good job analyzing a single market, say Oil.  But here you have a homogeneous target.  We are just talking about the Oil market.  And macroeconomics does a pretty good job not just with Oil but with many other markets too.  What it does a poor job of is when you take things to the next level and try to understand what goes on when many markets interact.  But that "meta" question is more important than understanding markets where each is considered as a stand alone proposition.  It is when you combine all the markets together that you get the world economy as a whole and that's what affects everyone the most.

So one idea behind Metaeconomics is to move to the next level and study large aggregations of markets.  But I want to narrow the focus from the large vague mission of understanding the economy as a whole.  Economists have been trying to do that for something like 200 years.  But the recent experience with the 2007-2008 crash shows just how poor a job they are doing.  This very problem is one of the reasons I recommend Wolf's book so highly.

Wolf looks at all the main strains of economic theory.  I mention Keynsianism to give you an idea of what I am talking about.  I mention it because it is the one people are most likely to have heard of.  But he works his way through all the major strains including one that was popular about 150 years ago and went out of favor about a hundred years ago.  All the theories share one common attribute.  Somewhere along the line they have gotten some major event wrong.  Paul Krugman has been championing a Keynesian approach to our current economic malaise for several years now.  But Krugman would be the first to admit that Keynsianism has made major blunders if applied uniformly over the last 60 years or so.  The problem is that it's not just Keynsianism.  Pick your poison.  Every one of them results in a major blunder when applied to the economic history of the last 100 years or so.  In fact, what typically happens is that a particular strain becomes the favored one.  Then it results in a massive blunder and it is replaced either by a new strain or a rehabilitated version of an older one.  But none of them gets it right all the time.

Now this is not a unique problem.  It happens all the time and all over the place.  To pick a definitely uneconomic example:  there is the argument among scientists about the nature of light.  There were two strains, the "it's a particle" strain and the "its a wave" strain.  The argument went back and forth for hundreds of years.  One strain would gain favored position.  Then some new experiment would come along and embarrass it resulting in the other strain gaining favored position.  The impasse was finally broken by a "third way" strain.  Light behaves like a particle in some situations and like a wave in others.  But in some situations it behaves like neither.  It is a "photon", neither completely particle nor completely wave.

Physicists arguing about the nature of light accepted the results of well conducted experiments.  They just argued about the way those experimental results are interpreted.  And that's the way economists should behave.  But a lot of the time they don't.  There are adherents to each of the major strains of thing in economics.  Mostly they just stick with their pet theory and argue that it is more right than the other guy's.  There needs to be a score keeper.  And that's part of my proposal.  But before I get to that, I want to make another digression.  Why?  Because I can.

I was never much interested in Geology.  This was in spite of the fact that I had an aunt whom I adored who had a degree in and a love for Geology.  I like areas where there are a few key organizational principles.  Geology at the time was the opposite.  Geologists knew a lot about a lot of things.  They had characterized tens of thousands of minerals, for instance.  And they knew a lot about some geological phenomena.  They knew, for instance, how to turn a large mountain into a series of small hills by adding large quantities of weathering and time.  What they had no clue about was how you built up a mountain or why the pattern of prevalence of minerals was what it was.  So, to oversimplify, Geology was a bunch of bags of unrelated facts.

Then Plate Tectonics came along.  Plate Tectonics provided the organizational principle under which you could arrange your previously unrelated bags of facts.  Plates collided to push up mountains.  These and other processes explained why minerals appeared in certain patterns.  And so on, and so on.  I became familiar with Plate Tectonics in the late '70s and early '80s.  Somewhere along the way I came across an "Introduction to Geology" text book that had been published in 1968.  This was about the time when the early formulations of Plate Tectonics were being created.  But it was far to soon for a new theory to appear in a text book aimed at undergraduates.

So there it was.  One chapter would discuss one bag of facts.  Another chapter would discuss another bag of facts.  If you weren't looking for it you wouldn't notice it.  There was no organizational principle to tie the chapters together.  They were each required to stand on their own two feet with no buttressing ideas to show how they related to the material in other chapters.  A lot of people took a Geology class and were perfectly happy.  For them the "bags of facts" approach was good enough.  But "bags of facts organized and presented so that they all reinforce and support each other using the scaffolding of some organizing principals" works much better.  I contend that Economics is now in the same position as Geology was before the advent of Plate Tectonics.

Now, for another digression.  But this digression leads us pretty directly to where I want to go.  There is in Atmospheric Sciences (the academic version of "weather man") circles something called a GCM.  GCM is often referred to as a Global Circulation Model but the preferred styling is as a General Circulation Model (at least, according to Google).  These are mathematical constructs that model the weather.  At their foundation the models are simple.  There is a branch of mathematics called Fluid Dynamics.  This is the study of the flow of fluids around shapes.  Air is a fluid and it flows around shapes like mountains.  So the equations of Fluid Dynamics, originally developed to understand how to make wings and propellers on airplanes work better, apply to how the weather works.  A subspecies of Fluid Dynamics is the modeling of problems on computers.  This leads to the now well developed field of CFD, Computational Fluid Dynamics.  CFD can be used in any situation involving fluids and shapes.  Change a few parameters and you can use the same CFD program to study the hulls and propellers of ships or how stars go supernova.

At some point the Atmospheric Sciences crowd said "Hey!  There are these cool CFD programs out there.  I bet we could use them to model the weather."  So they did and got interesting results.  One of the early efforts was the Carl Sagan "Global Winter" initiative.  Very simple CFD models were used to model what would happen if a large number of nuclear explosions took place over a short period of time.  The short answer turned out to be "bad things".  There was a lot of argument about whether Sagan and his people had gotten it right.  And there was general agreement that the Sagan model was too simplistic.  Still the result was interesting and the model was interesting.  So people picked and poked both with respect to the model and with respect to the data.  To this day you can still get a spirited argument about whether the Global Winter scenario is valid or not.  The one thing people agree on is that the model was an interesting and useful tool.

Then along came some other interesting and apparently unrelated data.  A fellow named Charles David Keeling decided it would be a fun idea to start continuously measuring the amount of Carbon Dioxide in the air.  He only had enough money to set up one measuring station.  He figured that the Maua Loa Astronomical Observatory in Hawaii was a good spot.  It was high on a mountain in a place that was away from large populations and industries.  It was effectively out in the middle of nowhere being pretty much smack dab in the middle of the Pacific Ocean.  When he started he had no real idea of what he would find.  Generally, he figured it would go up and down but he had no idea what the long term trend would be.  And it does go up and down.  But the up and down follows the calendar, religiously.  It always goes up in the Summer (in the Northern hemisphere) and down in the Winter.  This was interesting but not that interesting.  What was "that interesting" was to compare the year over year figures.  Pick a month or average a year.  It doesn't matter which month or which pair of years you pick.  Every year the new numbers are higher than the old ones.  Every time.  That was completely surprising.

After he had been at it a while Keeling published his data.  The firs thing that happened was people went at him for not doing the measurement right.  But everything checked out.  He was doing the measurement right.  Then people stood around for a while waiting for the trend to break and the year over year numbers to go down.  After they had waited a few years they gave up on that.  And in the mean time others started setting up similar equipment and making similar measurements.  And everyone got pretty much the same result.  The amount of Carbon Dioxide in the atmosphere was going up, once you subtracted out annual variation (the seasonal change).  And by this time people knew that Carbon Dioxide was a greenhouse gas.  It contributes to the "greenhouse effect".  It's warmer in a greenhouse than it is outside.  So people started asking "is the earth suffering a greenhouse effect such that it is getting warmer"?  This was the start of the whole "Global Warming" issue.

I don't want to get into the "argument".  Scientists say "yes, the earth is warming".  There is a well organized "denailist" community.  But except for a few pet scientists it is entirely composed of people who for political or economic reasons find Global Warming to be an "Inconvenient  Truth".  One thing the denialist crowd did was to loudly shout "show me the proof".  And they had enough political pull to make sure they were and are heard.  One of the most important responses of the scientific community was to pull out and dust off GCM models.  Then the denialist community loudly shouted "there is this and that and the other thing wrong with your GCM".  Scientists responded by enhancing and improving their GCMs.  The modern ones are very sophisticated and do a very good job.

One unexpected side effect of this whole Global Warming GCM effort has been to settle a lot of debates within the science community about how weather works.  In case after case someone says "it works this way".  People build "this way" into one or more GCM models and the model either works (does a good job at predicting the weather) or it doesn't.  If the GCM using a particular theory of how something works does badly people take a hard look at the theory.  If after a certain amount of tinkering and tweaking the theory still doesn't work, as measured by the accuracy of GCMs, the theory gets discarded in favor of the ones that do work.  The GCMs have come to represent a neutral scorekeeper in determining which theories are right and which are wrong.  This has resulted in a considerable amount of advance in our understanding of the weather.  Weather theories do not go on forever.  Some live and some die.

And this is a big problem with economic theories.  They are all "zombie" theories.  They can't be killed.  As noted above, Wolf spends a considerable amount of time on a theory from the 1800's.  It was dead a hundred years ago and then it was not.  It can't seem to die even though it has major flaws that no one has figured out how to fix.  And it's not just this one theory.  It's all of them.  There is no neutral scorekeeper in the Economics business.  So:

I propose that the first order of business for Metaeconomics be to undertake to build GCMs that model not the weather but the economy.

Weather GCMs model the flow of a fluid, air.  Economic GCMs would model the flow of money.  Money is not a fluid so Fluid Dynamics is not an appropriate foundation.  But money does have properties that follow mathematical rules.  At the simplest level, there are processes that create money and processes that destroy money.  Other than that, money flows from one place (typically an account) to another.  This flow is lossless.  The total amount of money doesn't change, just its location.  Economists think they understand all three behaviors.  You can find many learned papers on where and under what circumstances money is created.  You can find many learned papers on where and under what circumstances money is destroyed.  The rules of accounting are Johnny on the spot to demand that money be always exactly accounted for.  So, after you have accounted for the creation processes and the destruction processes, you have a "conservation" law.  Other processes (e.g. all those processes that neither create not destroy money) conserve the amount of money.  This, like Fluid Dynamics in the "weather" case, provides enough of a foundation to permit the flow of money to be modeled mathematically.

There are other issues.  Many billions of dollars (or the equivalent in Pounds Sterling, or Yen, or Deutschmarks, or etc.) are expended measuring with extreme accuracy exactly how much money is at a specific place at a specific time.  The process is called accounting and the expectation is that the location and amount of money in very complex financial entities can be measured so accurately that the books balance "to the penny".  Atmospheric Scientists would be ecstatic if they could measure the basic parameters of weather to anything like a similar accuracy but they can't.

This is a roundabout way of saying that a GCM for economics will look a lot different than a GCM for the weather.  In theory the weather is simple.  But the amount of data that must be processed through these simple processes stresses the capabilities of even our largest supercomputers.  The economic GCM has the opposite problem.  The amount of data is modest but the complexity of the system is immense.  And the "hard thing" for each of the two systems is different too.  In weather GCMs there is the "butterfly effect".  The idea is that if a butterfly flaps its wings at the wrong time in India it may eventually affect the path of a Hurricane in the Caribbean.  This is a cute way of getting at the fact that small changes in the initial data can snowball into large differences in a forecast.  Weather GCM modelers are forever trying to come up with new ways to deal with this well known problem.

In the case of economic GCMs the problem is "animal spirits".  This cute phrase has to do with the fact that "human beings making decisions" are an integral part of how the economy behaves.  Given absolutely identical situations humans may react quite differently.  Theoretically, this should wash out when we replace one individual with a large number of individuals.  Instead of dealing with the vagaries of a specific individual we are dealing with the statistical average of a number of individuals.  This is supposed to "wash out" the variation and make crowds more predictable than individuals.  But it doesn't.  Crowds engage in "herd behavior" and the herd behavior is no more predictable than that of individuals.  Again, when confronted with the same situation the herd will behave quite differently in one situation than it does in another essentially identical situation.  This "different decision in the same circumstances" problem what economists mean when they talk about the "animal spirits" problem.

As a specific example, suppose you give a bunch of people a raise.  Simplistically, they have two choices:  they can save the additional money or they can spend it.  In the actual case we are dealing with the extent to which, on average, people save versus the extent to which, on average, they spend.  If the answer is "mostly save" the economic result is one thing.  If the answer is "mostly spend" the economy result is quite different.  The "animal spirits" problem drives economists nuts pretty much the same way the "butterfly effect" problem drives Atmospheric Science people nuts.

I propose that in the initial round of economic CGMs we input the animal behavior parameters (e.g. the save/spend ratio is 36% save at a particular place at a particular time) as data.  But once we have some monetary GCM models that work pretty well we can experiment with different animal spirits models.  If a particular model does a good job of reproducing the actual behavior of people in a variety of situations then it is a pretty good model.  If it doesn't then either the model needs more work or it needs to be discarded.  This is exactly what the Atmospheric Sciences people do with their weather GCMs.  They will plug in various approaches to dealing with a specific situation and see which one seems to work the best in the model.  Many approaches can be tried on many situations because there are a number of GCM models and even more modelers.

Even the objective of various weather GCMs are different.  Some are set up to predict the weather for the next few days.  Others are set up to predict trends lasting months or years.  Still others are set up to model much longer periods of time.  How are they tested?  "Initial conditions" data is input.  In the case of a "next few days" GCM it might be yesterday's actual weather.  The model is then run and the output sampled to see what the high temperature (or rain, or wind, or any number of other things) gets forecast to be for each of the next several days.

Economic GCMs can be built and used in a similar manner.  One might be used to forecast next quarter's GDP.  Another might look out a year or more.  The formal objective of a Metaeconomic GCM would be to model the economy of the entire world.  But "micro" forecasts could be prepared that covered only a single country or region.  Then there's the problem of "the weather only did one thing yesterday".  The Atmospheric Science people deal with this problem by modeling various historical periods.  If we start with the weather exactly thirty years ago does the GCM accurately predict what we know happened over the next few days thirty years ago?  By picking a variety of situations from history Atmospheric Scientists are able to test drive their GCMs in a wide variety of situations.  This eliminates GCMs that are hard wired to get a few cases right or those that were just lucky.

Monetary GCMs can be tested in a similar manner.  They can test drive their models over a number of points in history or of a number of countries or regions.  Since modelers would be starting from scratch, the best place to start is with scenarios that are generally believed to be easy.  Then as the models improve you keep trying them on harder and harder scenarios.  Given that everyone missed it the 2007-2008 scenario deserves an "extremely hard" rating.  But I expect GCMs to initially fare very poorly, even on the "very easy" scenarios.  But the failures should teach important lessons.  And the fundamental lesson of Science is that you learn more from failure than you do from success.

I expect all the current strains of economic thinking in their pure forms to fail.  But consider F=MA, the famous equation from Newton.  It is known to be wrong.  So why do we keep it around?  Because it is much simpler and easier to deal with than the correct Special Relativity formulation and it works well enough in a lot of common situations.  So engineers and scientists have developed a handy rule of thumb.  If the numbers fall into a certain range then use "F=MA" with confidence.  Otherwise, they use the more complex Special Relativity version.  Perhaps a similar thing can be done with the various economic strains.

If the numbers fall into this range then use Keynsean methods.  For this other range use this other method.  And so on.  Perhaps there is a "meta" rule that would allow a combination of strains to work in a far broader wide range of situations than any one pure strain now does.  That would definitely put us ahead of where we are now.  And it might turn out to be the case that there are ranges of numbers that we actually encounter in the real world where none of the strains work.  That points us to a place where a new strain needs to be developed.  The details of how the field progresses don't matter.  The point is to make the field progress, hopefully much faster than it now does.  The current "zombie strain" where no strain ever completely dies (or even gets completely replaced with a "new and improved" version of itself) is impeding progress.

And, in the same way that the weather GCMs are helpful beyond their ability to advance our knowledge of atmospheric sciences, the monetary GCMs would be helpful in improving the economy.  What's not to like about that?